Income Inequality, Poverty and Progressive Taxation Essay

Income inequality refers to the extent of unequal distribution of household income among various groups in an economy(Green, Riddell & St.-Hilaire, 2016). It measures the gap between the top richest or highest income earners, and the bottom poorest or lowest income earners (Green, Riddell & St.-Hilaire, 2016). The growing income inequality has been a concern to the OECD and other national macroeconomic policymakers. High-income inequality is associated with both economic, social and political risks. When a country has a high-income inequality, it suggests that there is unequal sharing of the outcome of its economic growth. It also affects the economy by dragging down the GDP growth. Inequality can also lead to political risks such as uprising against the government. Factors that contributed to the growth in income inequality include globalization, technological changes as well as government policies (Polachek, Tatsiramos & Cappellari, 2016).

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Income inequality relates to poverty rates. Poverty rate refers to the ratio of the number of households with incomes falling below the poverty line (Agenor & Montiel, 2015). The poverty line is considered as the half of the median income of the total population. High poverty rates are associated with high-income inequality. Thus, failure to reduce income inequality is often related taken as the ineffectiveness of the economy's poverty reduction policies. The World Bank (2013) estimated that more than 767 million people globally lived on less than $1.90 a day in 2013. This implies that more than 10% of the total world population lives below the poverty line. This is not desirable to the economy since people living below the poverty line are not able to exploit their full economic potential. It is also undesirable since it increases the governments' expenditure on welfare services and, in most cases, leaving less for development spending (Dornbusch, Fischer & Startz, 2008).

Taxation is one of the policies taken by various governments to reduce income inequality as well as poverty rates (Slemrod, 2010). Progressive taxation is a tax system in which the tax rate increases with an increase in household incomes (Slemrod, 2010). In this case, people with high incomes pay higher incomes than those with lower incomes. For instance, the US income tax rate is 10% for single persons earning up to $9,325 annually but increases progressively with individuals earning $418,401 or more being taxed at 39.6% (Scheve & Stasavage, 2017).

Effectiveness of Progressive Taxation

Progressive taxation is one of the most popular policies employed by various governments to reduce income inequality, among other macroeconomic goals. Progressive taxation can reduce income inequality especially if the tax revenue collected is redistributed to programs benefitting the low-income earners (Engler & Strehl, 2016). Where progressive taxation is used to lower income inequality, governments fund welfare programs such as education, healthcare and other social programs to improve the living standards of the poor. However, progressive taxation has not been effective in reducing income inequality in most countries (Looney & Moore, 2015).

Despite almost all countries adopting the progressive taxation system, OECD reports that income inequality has increased across countries over the last two decades. According to Duncan & Sabirianova Peter (2016), progressive taxation is effective in reducing disparities between observed incomes but has done little to lower the actual uneven distribution of income as measured by consumption-based GINI Coefficients. The effectiveness of progressive taxation is reduced by the fact that pre-tax earnings are extremely skewed. There are already extreme inequalities between the pre-tax incomes of the top earners and bottom low-earners. In most countries, the top 10% richest citizens benefit more from economic growth than the bottom 10%. If incomes of the high income-earners are increasing at a faster rate than the earnings of the low-income earners, the year-over-year income inequality rises despite the presence of progressive taxes. In such cases, the income inequality can only be reduced if there is an increase in the tax rate for the higher income tax brackets. However, progressive income tax rates are rarely adjusted annually or regularly due to the unintended consequences. Attempts to improve the progressivity of tax rates can have a negative impact on equity and efficiency of a tax system (Duncan & Sabirianova Peter, 2016). In developing countries, higher progressive taxes lead to the growth of the underground economy and tax evasion. The impact of progressive taxes on income inequality is less in countries with weaker institutions than in those with stronger institutions (Duncan & Sabirianova Peter, 2016).

High progressive tax rates reduce economic growth thus worsening income inequality. High tax rates discourage investments thus lowering economic growth. This is because the top richest citizens are the most significant owners of capital and investments. Globalization has also limited the effectiveness of progressive taxes. This is because investors, including corporations, can easily transfer their economic activities to countries with favorable taxation policies. This reduces the total investment activity in the country and increases unemployment thereby increasing the income inequality. Attempts to reduce the income inequality between high and median income earners lower the growth of the economy (Biswas, Chakraborty & Hai, 2017). Several US multinational corporations have shifted their operations and profits to countries with favorable corporate taxes such as Ireland and Sweden (Clark Neely & Sherrer, 2017).

In some countries, capital gains tax policies have neutralized the effect of progressive taxes on income inequality. Some nations, like the US, have separate tax rates for capital gains and losses. For high-income bracket taxpayers in the US, the capital gains tax rate is less than the ordinary income tax rate for the highest income tax bracket. Because capital gains form a significant percentage of the total incomes of the top wealthiest taxpayers, progressive income taxes have no significant impact. In the case of the US, the income inequality after taxes and before-tax inequalities are almost similar (Bryan & Martinez, 2008, p. 102). This implies that progressive taxes have had little impact on income inequality.

Conclusion

It is evident that progressive taxes have little, and in some cases, no significant impact on income inequality across the world. Higher progressive discourage investments and encourage tax evasion especially in developing countries. It leads to increased unemployment as sticky wages which worsen income inequality. Progressive taxation is a redistribution tool and cannot efficiently reduce the income gap between the richest and the poorest. Taking money from the rich and spending it on the poor does not help reduce inequality. Uneven distribution of income is an outcome of several variables. Economic policymakers should focus more on reducing poverty rates through the creation of employment, enhancing the quality of jobs, investing in education and training as well as adopting policies that encourage business growth. The OECD and other policymakers should consider alternatives to progressive taxation such as fixing the minimum wage, social security and enhancing equality of opportunity.

References

Agenor, P., & Montiel, P. (2015). Development macroeconomics. Princeton (N.J.): Princeton University Press.

Biswas, S., Chakraborty, I., & Hai, R. (2017). Income Inequality, Tax Policy, and Economic Growth. The Economic Journal, 127(601), 688-727. http://dx.doi.org/10.1111/ecoj.12485

Clark Neely, M., & Sherrer, L. (2017). Corporate Inversions, Inside and Out | St. Louis Fed. Stlouisfed.org. Retrieved 22 April 2018, from https://www.stlouisfed.org/publications/regional-economist/first_quarter_2017/a-look-at-corporate-inversions-inside-and-out

Dornbusch, R., Fischer, S., & Startz, R. (2008). Macroeconomics. Boston: McGraw-Hill.

Duncan, D., & Sabirianova Peter, K. (2016). Unequal inequalities: Do progressive taxes reduce income inequality?. International Tax And Public Finance, 23(4), 762-783. http://dx.doi.org/10.1007/s10797-016-9412-5

Engler, P., & Strehl, W. (2016). The Macroeconomic Effects of Progressive Taxes and Welfare. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2881186

Green, D., Riddell, W., & St.-Hilaire, F. (2016). Income inequality. Montreal: McGill-Queen's University Press.

Looney, A., & Moore, K. (2015). Changes in the Distribution of After-Tax Wealth: Has Income Tax Policy Increased Wealth Inequality?. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2642452

Polachek, S., Tatsiramos, K., & Cappellari, L. (2016). Inequality: Causes and Consequences. Emerald Group Publishing.

Scheve, K., & Stasavage, D. (2017). Taxing the Rich: A History of Fiscal Fairness in the United States and Europe. Princeton: Princeton University Press.

Slemrod, J. (2010). Tax Progressivity and Income Inequality. Cambridge, GBR: Cambridge University Press.

World Bank. (2013). Poverty Overview. World Bank. Retrieved 22 April 2018, from http://www.worldbank.org/en/topic/poverty/overview